Unpopular Wisdom: Tenuous Bonds

You hear it all the time: When interest rates start climbing, bonds start suffering. Indeed, some commentators go so far as to suggest that should rates rise fairly sharply, bond investors are doomed to suffer a capital loss on the order of those who got caught in the technology downdraft. Get out now, such commentators suggest, while the gettin' is good.

Though interest rate increases often do hurt the performance of bonds, it is not always the case — and it is not necessarily true for every issuance. Before you start jettisoning every fixed-income issue from your clients' portfolios, consider some facts that can help you to buttress your clients' bond exposure and performance:

The value of a bond depends on its yield as well as its price.

Say, for example, you are invested in a bond portfolio that has a 1.5-year duration and yields 1.75 percent. If we assume interest rates rise 1 percentage point over the next year, we could expect to see a 1.5 percent decrease in the price of the portfolio. But the yield advantage of 1.75 percent turns the total return after a year into 0.25 percent.

Okay, 0.25 percent is not exactly a strong gain — but it's not a loss, either, and it is not the 1.5 percent loss that most investors seem to assume will occur.

Now look at a longer duration bond portfolio — let us say 10 years with a yield advantage of 5.5 percent. The same 1 percent rise in interest rates theoretically could result in a 10 percent loss, but yield helps us once again, and a subsequent fall in bond prices is offset by a 5.5 percent yield, resulting in a negative 4.5 percent total return. Still a loss, yes, but not exactly a catastrophic event.

Performance can be boosted by sector and industry rotation.

Each sector or industry of the bond market reacts differently to a rise in interest rates. In one instance, the banking industry may be hit harder than, say, the energy industry: People might cut back on their borrowing in the face of higher rates, but they have to continue pumping gas into their cars.

A money manager may also rotate through the various sectors, which include Treasuries, mortgage and asset-backed securities and corporate bonds, among others. Corporates, in turn, can be broken down between investment grade and high-yield.

A careful assessment of the sectors and industries that are likely to fare better in a higher interest rate environment may further protect a bond portfolio against erosion.

Performance boosts also can derive from effective issue selection.

Just as different sectors or industries react differently to rate rises, so do certain issues benefit more than others. A manager who successfully selects individual bonds can strengthen a portfolio. One auto manufacturer, for example, may be more heavily dependent on loans than another and therefore suffer more from higher rates.

Issue structure also can add value.

All bonds are not created equal — even bonds issued by the same company. Sometimes investing in the right structure pays off better than investing in the right company.

Would you rather be the first or last person in line to receive a free ice cream bar at the Taste of Chicago when you know quantities are limited? That is the idea behind senior versus subordinated debt structures: The senior debt holders receive the ice cream first, the subordinated debt holders get it last — assuming there is something left.

The bond market prices these debt structures differently. Knowing which is the better structure to own as interest rates increase may help improve performance.

Investors can achieve diversification by buying a variety of bonds or investing in a fund that does.

One fund may buy only corporate bonds; another may prefer credit-card asset-backed securities. Investing in both can achieve diversification and smooth out the performance of a portfolio.

A portfolio that is invested in a bond fund that features a wealth of bond varieties is better equipped to survive market turmoil than a fund that's exposed only to a certain type of bond.

Bond investors would be wise not to focus solely on interest rates. Although an increase in rates is typically a negative event for a bond portfolio, other factors affect performance and may override the impact of higher rates.